Fault Lines: How Hidden Fractures Still Threaten the World Economy (27 page)

Those who believe that markets are grossly inefficient would quickly construe this outcome as evidence that the stock market typically gets it wrong, and that theories that markets efficiently aggregate all public information into prices—versions of the “efficient markets hypothesis”—are hopelessly misguided. Yet nothing in the theory says the market should be spot on all the time. The market may not have full information—after all, even regulators were later surprised by the quantities of asset-backed securities the banks carried both on and off their balance sheets. Moreover, even if it assigns appropriate probabilities to all possible events, only one of those events will be realized. Viewed with the benefit of hindsight, especially if an extreme event occurs, the market will seem as if it got matters wrong, and indeed it will have done so. But this is not to say that anyone could have consistently done better. In the jargon of economists, that the market is believed to have rational expectations about events does not mean that it has perfect foresight.

More generally, there is a danger in judging risk taking while looking back from the depths of a crisis, especially one as severe as the recent one. From that perspective, any risk taking beforehand seems irresponsible, redolent of mismanagement. Conservatism seems prescient and astute—indeed, it seems so much in tune with the times that it becomes the strategy of choice after the crisis, when in fact more risk taking would be appropriate. However, the right way to judge actions taken before the crisis is whether the risk taking was expected to be profitable.

And it may well have been that shareholders, protected by limited liability from bearing the extreme losses induced by tail risk (because shareholders can simply abandon their shares when their value hits zero, whereas partners in an unlimited-liability partnership must repay the money owed to debt holders or forfeit their wealth), deemed the expected profits from taking on tail risk worthwhile—they took the gains while the debt holders and the taxpayer absorbed the tremendous losses. Put differently, Jimmy Cayne (of Bear Stearns), Dick Fuld (of Lehman), and Chuck Prince (of Citigroup) might still be feted as giants of the financial industry had events followed the most probable course. This is not to say that the risks they took on were good for society, only that they may have been reasonable bets for shareholders to take.

The actions of corporate boards, which are the representatives of shareholders, might give us a sense of where shareholder interests lay. Not all boards were equally competent, but Citigroup’s board, with stalwarts like Robert Rubin, the former treasury secretary and CEO of Goldman Sachs, might give us an inkling as to what knowledgeable shareholders might have opted for. There is evidence that this board pushed Citigroup into taking more of the risk that brought it to its knees.
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Although we cannot tell whether the board was independent or in management’s pocket, it apparently did not restrain the bank’s risk taking.

Finally, equity markets were not entirely unaware of the risks. From the second quarter of 2005 to the second quarter of 2007, the two-year implied volatility of S&P 500 options prices—the market’s expectations of the volatility of share prices two years ahead—was 30 to 40 percent higher than the short-term one-month volatility.
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This figure suggests that the market expected the seeming calm would end, even though the high level of the market indicated it did not place a high probability on events turning out badly for shareholders. But this is precisely how we would expect the market to behave if it believed the banks were taking on subsidized tail risk.

Thus far, as we have moved through the corporate hierarchy, from trader to risk manager to CEO to corporate board to shareholder, we have found little concern anywhere about the tail risks that were building up, especially in the aggressive banks. Many of the actors—traders, management, and shareholders—typically focused on the advantages of taking the tail risk. In insurance parlance, they would get a share of the premiums that flowed in while the going was good, and they would be protected by limited liability from having to make massive payouts if the extreme risk hit. Who then would absorb the losses?

Typically, the answer ought to be the bank’s debt holders. In the case of commercial banks, some were FDIC-insured deposit holders, who would not bear losses in any case, while others protected themselves by lending short term and demanding security to back their lending. If defaults on asset-backed securities mounted, the short-term lenders thought they would be able to withdraw ahead of the collapse. But not all of them could hope to escape without taking a hit. Why were they not more worried?

Similarly, why were holders of long-term, unsecured debt not extremely fearful, especially given the higher future expected volatility reflected in share options? Bank debt holders typically hate volatility, as they get none of the upside gains and bear all the downside risk. Bank debt spreads, a measure of a bank’s anticipated risk of default, remained very moderate until just before the crisis.

It is hard to argue that debt holders were ignorant of the risks, especially when equity options markets seemed to be signaling possible trouble. The obvious explanation for their continued exposure to risk is that debt holders did not think they would need to bear losses because the government would step in. There were two possible reasons for this complacency—reasons that were in fact borne out by events. First, unsecured bondholders worried less than they should have because of the prospect of direct government intervention in housing and credit markets if matters took a turn for the worse. Second, the institutions that took the most risk were those that were thought to be too systemic to be allowed by the government to fail. The bank’s debt holders would not have had to face any risk of default if the government bailed the firm out. Not only would confidence in a bailout have kept debt costs from rising in proportion to bank risk taking, but also, with little concern expressed by debt holders, management had an even broader license to take on leverage to boost returns for equity.

Consider the nature of the tail risks. Unlike ordinary loans or individual mortgages, where defaults occur in isolation, highly rated, diversified mortgage-backed securities were likely to risk default only if mortgages across the country defaulted. If such an improbable eventuality were to occur, the government would likely be drawn in to supporting the market for housing and for housing finance: it could not possibly sit idly by as millions of homeowners defaulted. Similarly, when such a systemic event occurred, not only would large banks find refinancing difficult, but corporations ranging from the large to the tiny would also face significantly greater financial constraints. Again, it was unlikely the Fed would stand by idly if liquidity vanished, especially given the promises Chairman Greenspan had made. So the systemic nature of tail risks ensured that banks would be collectively in trouble if a crisis occurred, and that government support would be forthcoming. This mitigated the costs of those risks.

And that support has indeed been forthcoming. Specifically, in order to support the housing market, the federal government has introduced tax measures that encourage home ownership, including the first-time home buyer’s tax credit. Since September 2008, Fannie Mae, Freddie Mac, and the Federal Housing Authority have lent hundreds of billions of dollars to low-income borrowers in an attempt to keep house prices from collapsing. The financial website
Bloomberg.com
estimates that in 2009, the Fed and the Treasury together purchased $1.3 trillion worth of agency-issued mortgage-backed securities, 76 percent of the gross issuance (including refinancings), and more than three times the net increase in the size of the market. Estimates suggest that these purchases lowered mortgage rates by about 75 basis points.
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The special inspector general’s report to Congress on the Troubled Asset Relief Program (TARP) in January 2010 states: “The government has done more than simply support the mortgage market. In many ways it has become the mortgage market with the taxpayer shouldering the risk that had once been borne by the private investor.”
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The
Financial Times
reports Neil Barofsky, the special inspector general, as saying: “All of the things that were broken in the housing market and the different roles that different private players have played, some of which we recognize now … actually contributed to the bubble and to the ensuing crisis, are really being replicated by government actors.”
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Even outside the housing market, the Fed pulled out all stops, especially after the collapse of Lehman. The Fed cut interest rates to rock bottom and created a variety of innovative programs to lend to the private sector, while the Treasury recapitalized firms through TARP. The Federal Deposit Insurance Corporation (FDIC) also chipped in by temporarily insuring all bank debt in 2008 and upping the quantum of deposit insurance. Banks that remembered the Fed riding to the rescue in 2001 with rock-bottom interest rates, and Alan Greenspan’s subsequent dictum that the Fed would “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion,” were not wrong in anticipating that they would be helped out of a tight corner yet again. The banks that had taken on liquidity risk and survived were rewarded with substantial profits—but some did not live to see happy days return.

Perhaps an equally important driver of bank bond-holder complacency was the knowledge that the large banks they had lent to were likely to be deemed too systemic to fail by the authorities. Herd behavior put the issue largely beyond doubt: if many large banks took the same tail risks, they would all be weak at the same time, and the chances that the government would risk a panic by letting any one of them go would be proportionately diminished. Henry Paulson, secretary of the treasury and thus the leader of the rescue in the Bush administration, writes about the FDIC-led resolution of Washington Mutual in September 2008:

Thus even though shortly before WaMu’s resolution the market fully expected debt holders would not be paid in full, and even though the FDIC had the full legal authority to impose losses on the bondholders, the secretary of the treasury expressed remorse over the action. Given that the only time a large, well-diversified bank can get into trouble is in the midst of a nationwide downturn and possible panic, the secretary’s logic would protect bank bondholders from ever suffering losses and remove an important source of market discipline on banker actions.

In sum, if bank management had fully understood the risks they were taking, their decisions could have evolved as follows. In the early stages of taking on a tail risk, such as the default risk in mortgage-backed securities or the liquidity risk in borrowing short term to fund long-term assets, they would have proceeded cautiously and even surreptitiously. After all, the profits from such activities would look a lot healthier if no one knew the risks they were taking. Accordingly, Citibank’s off-balance sheet conduits, holding an enormous quantity of asset-backed securities funded with short-term debt, were hidden from all but the most careful analysts.

But as enough banks imitated the innovators and took on similar risks, and as it became common wisdom among market participants that the market would be supported in the event of a crisis, there would have been strong incentives to load up on the tail risks, even if such activity became visible. The market would have focused on the profit potential of such risk taking, knowing that most of the losses, in the remote eventuality that they occurred, would be passed on to the government and the taxpayer. Indeed, an entity financed with short-term borrowing, knowing that it would be unable to repay its debts if liquidity dried up, had a powerful incentive to double up on its bet that liquidity would always be available—by buying assets that would fall in value if liquidity dried up and by leveraging even more. The simple reason is that limited liability protected its shareholders against losing more if its bets went wrong and liquidity did dry up; and if it guessed right, it would make a ton of money.
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No wonder exposures to both mortgage-backed securities and short-term leverage increased steadily before the crisis.

Anticipation of government interventions would have made it even harder for any bank to justify a conservative stance during the run-up to the crisis. For instance, one of the rewards of maintaining a very liquid balance sheet is that when liquidity dries up in markets, the bank can purchase assets at bargain-basement prices from those who have been too aggressive. But if the Fed intervenes to lend freely at such times, the discount on assets is far less than it would otherwise be. Many troubled banks held assets through the crisis that they should have been forced to sell, reducing the punishment they suffered for maintaining illiquid balance sheets and reducing the potential gain to bottom-feeding conservative banks.

Finally, all this behavior increased the likelihood of the tail risk’s materializing substantially. When few banks maintain liquid reserves even while leveraging their balance sheets to the hilt, the slightest adverse shock can tip the system over into a full-fledged panic. Similarly, as purchases of mortgage-backed securities increase without much attention being paid to default risk, mortgage lending expands and the quality of lending deteriorates, making widespread default more likely if house prices start dropping.